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Wednesday, April 9, 2008

The Fed's Power Grab

Back in school, one teacher hypothesized that the Federal Reserve Chairman was actually the most powerful person in the world. At the time, I found that line of thinking to be a bit cute at the time. More recently, I am starting to believe that it is accurate.

As it stands now, the Fed's main responsibility is to manage the money supply. This is in and of itself a rather powerful position, however that is not the only power the Fed holds. The Fed also has regulatory power over the banking industry. Furthermore, unlike Congress which has to go through the process of turning a bill into law, the Fed can create regulations by decree. Last December that is exactly what the Fed did.

The proposal includes four key protections for “higher-priced mortgageloans” secured by a consumer’s principal dwelling:

Creditors would be prohibited from engaging in a pattern or practice of extending credit without considering borrowers’ ability to repay the loan.

Creditors would be required to verify the income and assets they rely upon in making a loan. Prepayment penalties would only be permitted if certain conditions are met,including the condition that no penalty will apply for at least sixty days before any possible payment increase.

Creditors would have to establish escrow accounts for taxes and insurance.

This is important because Congress has had several bills including H.R. 3915 floating around but none of them have become law. Unlike Congress, the Fed acted quickly and with no oversight. This action is rather nebulous as the Fed used its oversight responsibility over banks to regulate the mortgage industry. The Fed clearly used a liberal interpretation of its responsibility in order to create these new regulations.

From the standpoint of the financial markets, the key aspect of Paulson's proposed "Blueprint for Regulatory Reform" was to give the Federal Reserve the oversight of "market stability." As part of that, the Fed would extend its charge from commercial banks to investment-banking firms and other non-traditional market players, including hedge funds and private-equity firms, which had been little regulated, if at all, but capable of creating risks for the entire financial system.

If this plan is instituted, the Fed would have oversight over any financial services institution. That means if any organization deals in money the Fed can regulate them. What is even more troubling is that the Fed's oversight will be done in the name of "market stability". That could frankly mean just about anything and thus the Fed could soon regulate anyone that deals with money in the name of "market stability".

The Bear Stearns merger was hyperanalyzed on many levels, however one aspect that wasn't analyzed enough was just how much authority the Fed exhibited in that deal. The Fed took on the role of investment banker, rainmaker, securitizer, and most importantly the Fed forced all players to accept a deal over the weekend when normally such deals take months if not years. Bernanke said he struggled with the decision however he felt the market couldn't take the panic of Stearns going under. That may all be true however Bernanke just opened the door to all future Fed chairmen also taking any sort of unprecedented moves of power in the name of eliminating panic.

This won't be the last time that the market will face uncertainty and even downright panic and if the Fed can play investment banker, regulator, rainmaker, and securitizer all at once in order to avoid panic, then it frankly can do just about anything if it feels a panic is about to set in.

The Federal Reserve is looking at contingency plans for bolstering its lending power in case recent measures it has taken to unfreeze the credit markets fail, the Wall Street Journal reported on Wednesday.

Nothing is imminent, since the Federal Reserve still has room on its balance sheet for additional lending, the report said, adding that the internal discussions were part of efforts to identify options in case the credit crunch got worse.

One option would be to have the Treasury borrow more money than it needs to fund the government and keep the proceeds on deposit at the Federal Reserve, the report said.

Other options include issuing debt in the Federal Reserve's name, with the proceeds used to make loans or purchase other assets; and asking Congress for immediate authority for the Fed to pay interest on commercial bank reserves rather than wait until a 2006 law permits it in 2011, the Journal said.

The Fed has increased their regulatory power, their power to manipulate financial transactions, and now the Fed wants more power to be able to lend. Where does it all end? I am of the opinion that controlling the money supply is plenty of power, and regulatory power on top of it is quite a bit of power. I am also of the belief that absolute power corrupts absolutely and right now the Fed is consolidating most power over the financial markets.

While we all stand back and watch the Fed aggressively move to make sure that the credit crisis is remedied, we are also witnessing an increasing power grab by an organization that already has an obscene amount of power. If we all don't watch out, the Fed will soon enough have enough power to be very dangerous.